Forum Topics Loss Aversion
CQFocus
Added 5 years ago

Great thread here, love diving into this element of the investing framework. I thought I’d add a little geeky theory into the mix…

 

Whenever the subject of behavioural economics comes up I generally head for Thinking, fast and slow by Daniel Kahneman, great book. Kahneman discusses loss aversion as part of Prospect Theory in Part IV: Choices Chapter 26. Prospect Theory. I won’t delve too deeply into Prospect Theory here but essentially he posits that there are three cognitive features that make up Prospect Theory - Evaluation to a reference point, a principle of diminishing sensitivity, and loss aversion.

 

Couple of interesting nuggets which I think resonate with an investing focus:

 

  • An evaluation to a reference point can be set with prospect theory in mind e.g. it could be status quo or an expected gain or loss (I guess for investing it is an expected gain so size of gain is probably important - managing one’s expectations)
  • The loss aversion coefficient tends to increase (slightly) as the stakes rise - I see this connected with position sizing relative to one’s own portfolio
  • Experiments have shown that the average loss aversion ratio is 2-2.5:1
  • Optimism protects against the effects of loss aversion while loss aversion offsets exaggerated optimism (how to find the balance!?)

 

Once again, great thread, really enjoying reading everyone’s approaches here.

 

CalmQuietFocus

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ArrowTrades
Added 4 years ago

Nice one @slymeat. I agree with you that loss aversion is a thing. Emotionally, most people react stronger to losing as they do winning the same amount.

Another study I saw, where people were asked to estimate the size drawdown they thought the could handle in their portfolio. Conclusion was that most over estimate by double, meaning if they said 40% that when the drawdown is actually happening and they are down 20% that is about where they start to panic, deviate from their plan and make bad decisions.

As a result people set up their portfolios to aggressively, then combined with loss aversion can't stick to their plan when it matters. So I agree that in times of turbulence it's good to monitor how you are feeling. The key is not to discard it once things settle down but to use the feedback and try adjust your risk parameter accordingly for future drawdowns.

Finally, I also agree with the point that sometimes loss aversion can in part be explained by it not being equal and the downside being more impactful. For those familiar with Kelly criterion (risk reward model), the idea is to first ensure you can never go bust and then after that concentrate on maximising expected value.

The first Million is the hardest to make. The value of making a second million is nothing compared to the impact of losing the first one.

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Rapstar
Added 5 years ago

The Art of Execution

How the World's Best Investors Get it Wrong and Still Make Millions

By: Lee Freeman-Shor

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suttree
Added 5 years ago

AJX Bear. Sorry! edit below

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shadow
Added 5 years ago

A capital loss can be a tax benefit (as @suttree aluded to). And sometimes it's better to get out rather than hold an endless dog stock. 

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CHill
Added 5 years ago

I wish I learnt this lesson earlier in my investing journey @slymeat. Too often I found myself averaging down thinking it was the smart thing to do. And to compound it I would sell my winners when I thought they got "expensive". Essentially I was watering my weeds and pulling my flowers.

Although it did provide a good learning experience & all part of the investing process. Better to learn these things early on in your journey with less capital available.

Often people say "I'll sell when it gets back to my buy price". The market doesnt care what price you paid, if you wouldnt buy it today then the chances are you should sell.

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